This single reference in a 16-paragraph article resulted in the post being listed temporarily in the Blog Posts section of Google Finance's page for Alcatel-Lucent. Fifteen readers clicked to read the full article.

We don't know why Google chose to give one of our analyses a few hours of extra visibility or why an article that repeatedly cited Microsoft would end up on an Alcatel-Lucent page. Nevertheless, we are grateful for the attention and hope some of the new readers will find our pages interesting and worthy of regular visits.

27 January 2008

Michelle Leder's "Financial Fine Print, Uncovering a Company's True Value" convinced us that we need to spend more time reading the footnotes that accompany the financial statements in 10-Q and 10-K reports. Our approach to the footnotes had simply been to harvest numerical data for use in the financial models we build for each company under analysis.

Michelle is the founder and editor of footnoted.org, which is one of our favorite web sites. We believe that the, um, large legion of GCFR fans will be interested in Michelle's book and will want to read footnoted.org daily.

Right off the bat, one of Michelle's central theses is made plain. Companies have a tremendous amount of flexibility when calculating the data shown in the financial statements. The numbers are far more subjective than many people realize. Microsoft discloses this fact in the Basis of Presentation section of Note 1, when they say: "Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses." A lengthy list of examples follows.

In the Recent Accounting Pronouncements section of Note 1, we see that two changes approved by the Financial Accounting Standards Board in December 2007 won't become effective at Microsoft until July 2009 and then will be applied prospectively. The latter point presumably means the new rules will be applied to future transactions, but previous transactions won't be restated.

We also learned that Microsoft charged $395 million (about $0.04/share) last July to Retained Deficit/Earnings, which is a component of Stockholders' Equity. The charge was associated with changes in tax accounting.

In GCFR, all per-share calculations are based on the number of common shares outstanding plus the dilutive effects of additional shares that might be awarded as a result of stock options and other share-based compensation. The use of diluted earnings per share, instead of the basic EPS, has become widespread in recent years. What we didn't realize until we carefully read Note 3 was that companies can exclude certain share awards from the dilutive calculation. In Microsoft's case, the number of shares excluded are trivial, but we will be on the lookout to see whether the opposite might be true for other companies.

Footnote 4 addresses Unearned Revenue. According to accountinginfo.com, which makes clear a difficult topic, Unearned Revenue is cash received before services are provided. It is a liability because the amounts are theoretically refundable to customers if the service is not provided in the future. Microsoft's footnote doesn't disclose the nature of its Unearned Revenue, but the company is known to have arrangements with customers in which it accepts cash with the promise of providing some number of software upgrades in a defined period. Once those upgrades are delivered, the cash previously received can be recognized as Revenue.

The footnote indicates that Unearned Revenue was a $12.178 billion liability on 31 December 2007. We tried to see if there was a way to determine what percent of quarterly Revenue had previously been classified as unearned. However, since company undoubtedly took in new Unearned Revenue, we were unable to make this calculation.

It's well known that Microsoft has been actively repurchasing its shares. From Footnote 5, we see that the company spent more than $4 billion (at an average cost of $34.01) to buyback shares in last quarter. (It's easy to confuse millions and billions in this footnote. We cross-checked with earlier 10-Q's to verify the units.) Since the January declines in the stock market have reduced the price of Microsoft shares from $35.60 to $32.94, the company could decide to step up its purchases. The footnote informs us that $8.7 billion remains available under previously approved repurchase programs, which totaled $36.2 billion.

When we were looking ahead to the results of the December quarter, we stated that investment and interest income would probably decline because cash was being spent on share repurchases. We were surprised to see an increase in non-operating income, and it threw off our earnings estimate by $39 million. In Footnote 6, we see that Dividend and Interest income declined by $110 million. However, a $75 million loss in derivatives in December 2006 became a $48 million gain in December 2007. This $123 million swing explains the surprising increase in investment income.

The estimated costs of warranties for hardware and software are included as other current and non-current liabilities on Microsoft's balance sheet. These liabilities totaled $861 million on 31 December 2007, up $11 million from 30 June 2007. From previous disclosures, we expect that charges related to the Xbox game make up a substantial portion of the warranty provisions. The footnote, however, doesn't give us this visibility.

Note 8, Contingencies, describes the company's ongoing legal and regulatory challenges in the U.S. and Europe regarding its competitive practices. These matters have been well covered in the business press and elsewhere, and we didn't see anything newsworthy in the footnote. We observed that the company couldn't resist whining that complaints with regulators had been filed by a trade association of Microsoft competitors.

We hadn't realized the extent to which Microsoft and Alcatel-Lucent are entangled in legal disputes alleging patent infringements. (We knew that a $1.5 billion judgment against Microsoft was later overturned; we didn't know that this was one game in an ongoing match.) If current behaviors persist, lawyers specializing in intellectual property at both companies will be busy for many years to come.

Microsoft purchased aQuantive for $5.9 billion in cash in August 2007. Note 10 indicates that the purchase resulted in $6.2 billion worth of Goodwill and Intangible Assets. The note also indicated how the Intangible Assets (less than $1.0 billion) would be depreciated as an expense of the next few years. In Note 11, we learn that none of the $5 billion worth of Goodwill acquired is deductible.

In Note 13, Income Taxes, we had hoped we might get a better understanding of the differences between what Microsoft reports to public in conformance with Generally Accepted Accounting Principles and what Microsoft reports to the Internal Revenue Service and other tax authorities. However, we have proven unable to discern the true meaning of the following two sentences: "We have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $9.5 billion as of December 31, 2007 and $6.1 billion as of June 30, 2007, primarily resulting from earnings for certain non-U.S. subsidiaries which are permanently reinvested outside the United States. The amount of unrecognized deferred tax liabilities associated with these temporary differences was $2.8 billion as of December 31, 2007 and $1.8 billion as of June 30, 2007."

In this post, we are going to discuss the second metric: Debt/CFO, which is expressed in years. For example, a company may have short- and long-term debt that equals 2.5 years of Cash Flow from Operations. Higher durations indicate greater leverage in the company's capital structure, giving a different perspective than the more common LTD/Equity ratio (which we also consider). In a healthy company, debt payments are typically made out of future cash flows. If the cash flow isn't sufficient, the company might have to take on more debt (probably on more onerous terms) or sell otherwise productive assets.

For computing the Cash Management gauge score, our approach had been to give points for year-to-year reductions in the Debt/CFO ratio. This approach inadvertently penalized companies have little or no debt. If the debt level is low (e.g., one year of Cash Flow), then there is no need to be concerned with whether the level is static or declining.

Therefore, we have altered the scoring to reward low Debt/CFO ratios. We will still give credit for debt reductions, but it won't be the entire focus of the score.

The new scoring will be put into effect immediately. Previous scores will recalculated as they are needed for new analyses. The effects are not expected to be significant for most companies.

25 January 2008

We have analyzed Microsoft's (MSFT) financial results, as reported to the SEC on Form 10-Q, for the quarter that ended on 31 December 2007. We really appreciate it when a company submits a 10-Q on the same day they announce their results to the public. This gives us the earliest possible access to a full set of financial statements, and there is unlikely to be a discrepancy between the press release and the 10-Q.

It's been one year since Microsoft launched the consumer version of the Vista operating system. Revenues surged immediately, and profit growth followed with a bit of lag. Microsoft shares, which had moved up nicely in anticipation of the Vista release, traded in a narrow range for most of the year. Good third quarter results led to a late rally, which stalled when the overall market tumbled after the start of the new year.

Not satisfied by selling operating systems, server applications, business solutions, video game consoles, music players, and computer peripherals, Microsoft is determined to be a major player in the online advertising business. This puts the company in direct competition with Google and Yahoo. Earlier this year, Microsoft paid $6 billion for the aQuantive advertising network. The $240 million spent to acquire a 1.6 percent stake in Facebook, a company with minimal revenues, was a strategic investment. Of course, for Microsoft, $240 million is walking-around money; earlier this year they set aside $1 billion to repair faulty Xbox games

Revenue in the recent quarter exceeded the upper bound of the $15.6 to $16.1 billion range forecast by the company in October 2007. The Revenue increase over the year-earlier quarter was 30 percent. Year-over-year Revenue growth is now 26 percent, which is pretty rare for a large company and a rate not achieved at Microsoft in many years.

We expected Cost of Goods Sold (CGS) to equal 18 percent of Revenue, and the actual value was 21.6 percent. Our target was optimistic, but quarters with Gross Margins over 80 percent have been relatively common at Microsoft. We can't point with certainty to one reason why CGS was higher than our forecast. Using the 10-Q as a guide, our best guess is that the culprit was costs associated with the online services business, including intangible asset amortization and operation of data centers.

Microsoft significantly exceeded their forecast Operating Income would be between $5.9 to $6.1 billion. By our reckoning, Operating Income was 7.6 percent above a reasonable prediction.

Non-operating income was $39 million more than expected. (We thought the cash spent on share repurchases would lead to a greater reduction in interest income.) The Income Tax Rate of 31 percent exceeded the predicted 30 percent. Net Income exceeded the prediction by 6.3 percent.

Cash Management. This gauge increased from 10 points in September to 12 points now.

Value. Microsoft's stock price increased from $29.46 to $$35.60 over the course of the quarter. The Value gauge, based on the latter price, dropped to 6 points from 11 points three months ago (and 8 points twelve months ago).

The Overall gauge, led by Growth and Profitability, has now indicated very good scores in the mid-50's for two consecutive quarters. Since the stock price has retreated along with the overall market, the shares appear attractive.

The creation in April 2007 of Nokia Siemens Networks, a 50/50 partnership with the German powerhouse, has made it difficult to compare Nokia's current and past results. Recent financial statements fully consolidate the operations of the partnership. However, previous results, including the relevant year-earlier periods, do not include data for the businesses Siemens contributed to the partnership. This is a significant difference since the partnership would by itself be considered a large-cap company.

Nokia, headquartered in Espoo, Finland, is a global seller of cellular phones and the equipment for mobile phone networks. Cellular phones, especially lower-cost models, have become a commodity. More expensive devices compete both on style and technical features. The rapidity of new model introductions and changing consumer tastes leads to frequent alterations in the relative fortunes of the various manufacturers. Nokia is presently on an up-swing: it now has a 40 percent market share, far surpassing rivals Samsung and Motorola, according to one consultant.

Revenue was 12.3 percent above our estimate. We expected Revenue to be 19.6 percent greater than in the year-earlier quarter, and the actual increase was 34.3 percent. It is important to recognize that the magnitude of the increase was inflated by the formation of the Nokia Siemens Networks partnership. Since the partnership's Revenue in the quarter was €4.6 billion, an apples-to-apple Revenue growth rate is closer to 15 percent. The rate probably would have been higher if not for dollar weakness relative to the euro.

Days of Sales Outstanding (DSO) = 61.1 days, significantly greater than the 49.9-day level one year earlier. We don't have an explanation for this troubling increase in accounts receivable relative to sales.

Increases in Inventory and DSO (i.e., accounts receivables/sales) can be warning signs that revenue growth will slow in the future.

Growth. This gauge increased from 14 points in September to 15 points now. The score might not be valid since growth rates have been inflated by the accounting of the Nokia Siemens Networks partnership.

The measures that helped the gauge were:

CFO growth = 76.0 percent year-over-year, up from 8.1 percent the previous year

Net Income growth = 67.3 percent year-over-year, up from 19.1 percent (Net Income benefited from a change in the income tax rate from 24 to 17 percent!)

Revenue growth = 24.2 percent year-over-year, up from 20.3 percent in a year

The measures that hurt the gauge were:

Revenue/Assets = 136 percent, down from 182 percent in a year; the increase in assets was greater than the increase in revenue.

Profitability. This gauge increased from 13 points in September to 14 points now.

The increase in operating expenses was primarily the result of small increases in R&D and SG&A costs as a percentage of Revenue.

Value. Nokia ADR's edged up from $37.93 to $38.39 over the course of the quarter. Since the ADRs began 2007 at $20.32, the increased during the year was a dramatic 88 percent. Despite good operating results, it's not surprising that the Value gauge dropped to zero under these circumstances.

Now at 26 out of 100 possible points, the Overall gauge is weak despite substantial increases in revenue, cash flow, and earnings. This is because the stock has already surged (in part, because of the weakening dollar), costs went up faster than revenues, and the earnings increase was aided by tax changes.

23 January 2008

We have analyzed ConocoPhillips's (COP) preliminary financial results for the quarter and year that ended on 31 December 2007. The report included a myriad of data, but the company hasn't yet updated its Balance Sheet. This omission is not unusual in a preliminary report for Conoco, and it will certainly be rectified in the 10-K filed with the SEC. Since the GCFR analysis methodology requires Asset and Liability data to compute Gauge scores, we are assuming for this post that the Balance Sheet did not change materially from the end of September.

On 3 January 2008, Conoco gave investors some information on the energy industry's market and operating conditions during the fourth quarter, as experienced by the company. Conoco indicated that prices for oil and gas were higher (not exactly news), production was up, and refining margins were down (again). Conoco also announced that they would be adversely impacted ($250 million after-tax) by Alaska's retroactive production tax increase.

Conoco shares surged in the first half of 2007 and then bounced between $80 and $90. However, the stock market correction of 2008 knocked the share price down from $88 to close to $70.

When we analyzed Conoco after the September quarter, the Overall score was a weak 24 points. Of the four individual gauges that fed into this composite result, Cash Management was the strongest at 13 points. Value was weakest at 0 points. Many of the companies we analyzed in 2007 had weak Value scores; the market correction will probably result in higher scores.

Now, with the available data from the December 2007 quarter, our gauges display the following scores:

Revenue soared past below our $48 billion target. We thought that Revenue in the recent quarter would be 16 percent greater than the very weak sales figure of the year-earlier quarter, but Revenue actually increased by 27 percent.

As for Operating Expenses, we thought the Cost of Goods Sold (CGS) would be 71 percent of Revenue, and the actual value was 72.2 percent. Exploration costs exceeded our $250 million estimate by $18 million. Depreciation expenses were 4.2 percent of Revenue, fractionally below our 4.5 percent estimate. Sales, General, and Administrative (SG&A) expenses were 11.3 percent of Revenue, compared to our forecast of 12 percent. Non-recurring costs came in $54 million above our $200 million estimate

Even with higher costs, greater than expected Revenue pushed Operating Income 7.5 percent above the forecast value. [We should mention at this point that our definition of Operating Income, which we use for all the companies we analyze, is not identical to Conoco's definition. The differences can be discerned from the footnotes above.]

Non-Operating Income was also greater than we expected, in this case by $155 million. The good news story continued with the Income Tax Rate, 40.3 percent vs. 42.5 percent forecast. As a result, Net Income surpassed our prediction by a healthy 12.6 percent.

Cash Management. This gauge declined from 13 points in September to 11 points now. However, the score might change substantially when we get up-to-date Balance Sheet data.

The measures that helped the gauge were:

LTD/Equity = 24.7 percent manageable, down from 27.9 percent in December 2006

A lower Gross Margin was the main reason Operating Expenses as a percentage of Revenue increased.

Value. The normal GCFR approach is to compute the Value gauge score with the last share price of the quarter. Conoco shares ended December at $88.30, which wasn't much below their 52-week high. Now, however, the shares are trading less than $72. We did the calculations with both prices and found that the shares have not dropped enough to increase the Value Gauge more than a couple of points. If we use the current share price, and we also ignore the $4.5 billion asset impairment charge earlier in 2007 due to events in Venezuela, the scores start to become more attractive. But, we don't typically ignore special charges, and are not doing so here.

20 January 2008

While we wait for Home Depot (HD) to report its results for the quarter that ends later this month, we have produced an estimate of the Income Statement that will be included in the report. As explained below, the calculations rely on publicly available data, extrapolations of past results, and what we hope proves to be common sense. The estimates give us some insight into the operational and non-operational factors that might cause the company to surpass or fall short of Net Income expectations. Once the actual data becomes available, we will compare the estimated and actual data and note the deviations.

Given that the softness in the housing market is expected to continue for the rest of 2007 and the Company's commitment to invest in its key retail priorities, The Home Depot expects its earnings per share from continuing operations, on a 52-week basis, will decline by as much as 11 percent from last year. The fiscal 2007 earnings per share outlook reflects 52 weeks and does not include the impact of the 53rd week. The Company will have 53 weeks of operating results in fiscal 2007. The Company projects that the 53rd week will add approximately five cents to its earnings per share outlook for fiscal 2007.

Reported earnings per share in fiscal 2006 were $2.79. From what we can tell, and we don't have the complete picture, earnings per share from continuing operations were about $2.60. If we decrement the latter figure by 11 percent, and add back $0.05 for the 53rd week, Home Depot seems to be guiding us towards $2.36 per share for the fiscal year ending this month.

In the first three quarters of the current fiscal year, earnings from continuing operations were about $1.84 per share. This suggests that management expects fourth quarter earnings of around $0.52, depending, to a certain extent, on how many shares the company has repurchased.

The guidance doesn't directly address the quarter's Revenue, and this presents a challenge for us. In the January 2007 quarter, sales were $20.265 billion, but this value includes receipts from the former Home Depot Supply business. The Supply segment contributed 13 percent of total corporate Revenue in the previous year, which suggests that the comparable year-earlier quarterly sales value is closer to 17.6 billion. If we trim this by another 3 percent to reflect current market softness -- sales in the preceding quarter (October 2007) were down 3.5 percent -- our Revenue target for the January 2008 quarter is $17.1 billion.

Home Depot's Gross Margin as a percentage of Revenue averaged 33.4 percent over the last three quarters. Therefore, given our expectation for Revenue, the Cost of Goods Sold (CGS) in the January quarter should be about (1-.334) * $17.1 billion, or $11.4 billion.

Depreciation expense has been about 2 percent of Revenue, but we expect this to edge up to 2.2 percent because sales will slow faster than depreciation. It should be around $380 million (0.022 * $17.1 billion) for the quarter.

Sales, General, and Administrative (SG&A) expenses as a percentage of Revenue have been between 20 and 23 percent, with recent results closer to the higher end of the range. For the fourth quarter estimate, we will assume 22 percent. Accordingly, we're expecting SG&A expenses to be 0.22 * $17.1 billion, or $3.8 billion.

Our estimates for Revenue and Operating Expenses would result in an Operating Income of $1.6 billion.

Net interest and other expenses has recently been about $140 million per quarter. This value would decrease pre-tax income to $1.4 billion.

A 37 percent income tax rate is usually a pretty good estimate for Home Depot. This rate would suggest that provisions for income taxes will be $530 million, and Net Income will be $900 million ($0.50 per share, if the number of shares outstanding hasn't changed much from the October quarter).

This is $0.02 less than where we think the company guidance leads (see above), but given all the assumptions made, we feel like we are on the right track.

Please note that the tabular format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.

19 January 2008

Wal-Mart (WMT) will report on 19 February its results for the holiday-driven November-through-January quarter. While waiting, we have produced an estimate of the Income Statement that will be included in the report. As explained below, the calculations rely on publicly available data, extrapolations of past results, and what we hope proves to be common sense. Once the actual data becomes available, we will compare the estimated and actual data and note the deviations.

Company-provided revenue data for the first two months of the quarter gives us a leg up for this exercise. In November, sales were up 8.4 percent over the equivalent year-earlier period, but sales were down 0.7 percent when the comparison is limited to the same or comparable set of stores. In the December period, which includes the first few days of January, total sales were again up 8.4 percent. Comparable-store sales reversed course and were up 2.6 percent.

Sales data for January will be made public on 7 February.

When reporting third-quarter results last October, Wal-Mart management issued some guidance about the top-line sales and bottom-line earnings for the fourth quarter:

For the fourth quarter of fiscal year 2008, the Company estimates the comparable store sales increase in the United States to be between flat and 2 percent, according to Tom Schoewe, Wal-Mart Stores, Inc. executive vice president and chief financial officer. “We expect earnings per share from continuing operations for the fourth quarter to be between $0.99 and $1.03, resulting in the full year Company forecast for earnings per share from continuing operations of $3.13 to $3.17,” said Schoewe. “This guidance includes an anticipated restructuring charge for Seiyu of approximately $40 million after tax in the fourth quarter.”

We want to figure out the numbers between the top and bottom lines. By estimating these values, we gain some insight into the operational and non-operational factors that might cause the company to surpass or fall short of Net Income expectations.

Given the November and December sales results cited above, it seems reasonable to project the quarter's Revenue at 8.4 percent above the $99.1 billion figure achieved in the January 2007 quarter. This would be $106.3 billion. It's possible, of course, that the slowing economy might trim January's growth rate below that achieved in the earlier two months.

Wal-Mart's steady, unheralded progress at improving their Gross Margin as a percentage of Revenue is clear from the first figure. It's also obvious that the Gross Margin is purposely lowered, by about one percent, in the fourth quarter to attract high-volume holiday sales. (An alternative explanation would be that the mix of goods sold in the holiday period is less profitable than the mix sold in the other three quarters.) Using this information, we will look for a Gross Margin of 23 percent in the current quarter. Given the revenue forecast above, our estimate for Cost of Goods Sold (CGS) in the January quarter is 0.77 * $106.3 billion, or $81.9 billion.

We see from the second figure that Sales, General, and Administrative (SG&A) expenses as a percentage of Revenue have been creeping up and show an even greater seasonal pattern. Since the Revenue level in the fourth quarter is so much greater than the other quarter, SG&A expense in the fourth quarter as a percentage of Revenue is 1.5 to 2 percent below the rate in the other quarters. This is because SG&A expenses are relatively more fixed and less variable with Revenue than the CGS. Based on the figure, we're expecting SG&A expenses to be 17.5 percent of $106.3 billion, or $18.6 billion.

We'll also assume, in accordance with management's guidance, a non-recurring, special operating charge of $40 million to account for the Seiyu restructuring.

Our estimates for Revenue and Operating Expenses would result in an Operating Income of $5.8 billion.

Net interest and other income has recently been about $600 million per quarter. We also need to deduct about $100 million for minority interests. These values would increase pre-tax income to $6.3 billion.

Wal-Mart estimated that the average income tax rate for the current fiscal year would be between 34 and 35 percent with some quarter-to-quarter volatility. If we assume the higher rate, the provisions for income taxes will be $2.2 billion, and net income will be $4.1 billion ($1.01 per share, if the number of shares outstanding hasn't changed much from the October quarter).

Please note that the tabular format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.

Disclosure

This blog describes and gives examples of a particular quantitative methodology, relying on published financial statements, to analyze businesses. The methodology does not evaluate every aspect of a company's finances or operations. Other analytical techniques may be better suited to some evaluations, depending on the type of business or the goals of the analysis. The material in the blog is not investment advice, nor does it constitute an offer or solicitation to buy or sell any security. The author might have, might once have had, or might be considering a position in the companies mentioned. Specific positions will not be disclosed. While good-faith efforts are made to use reliable information sources and to provide accurate analytical results, accuracy is not guaranteed. All results are subject to change without notification. Application of the analytical methodology described in this blog requires that various assumptions be made. The assumptions are generally not disclosed and are subject to error, invalidating some or all of the analysis results. In looking for trends, recent financial data is compared to historical financial data; however, underlying differences in the assumptions or presentation of the data might degrade or invalidate these comparisons and could produce erroneous or misleading results. Readers should independently validate any information in this blog that causes them to consider making or not making a financial transaction.